Category: Financial statements

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Some of the key points IFRS 16 requires:

Application:

IFRS 16 “Leases” is effective from 1 January 2019 with earlier adoption permitted. The standard primarily provides accounting treatment on leases for lessees. The impact on lessors is almost nil.

Long term leases:

IFRS 16 classifies leases into two main types. First is the short term lease, these are the leases which are for a period of 1 year or less than that. The second type of leases is long term lease; these are the leases whose duration is more than 1 year. IFRS 16 is applicable on long term leases.

Right of Use assets:

A right of use asset is an asset which is been leased by a lessee on a long-term lease i.e., the lease period is of more than 1-year duration. The right of use means the lessee has effectively rights of use of assets almost similar to that of an owner.

Capitalization of right of use assets:

IFRS 16 requires lessee to recognize a right of use asset in its balance sheet, as non-current asset, for the long-term leases where certain conditions are met. The capitalization of right of use asset shall be done at the present value of lease payments to be made over the life of the lease.

Lease liability:

IFRS 16 requires recognition of lease liability as a corresponding credit entry to recognition of right of use assets. Thus, a lease liability will be booked at present value of lease payments over the life of the lease. The initial recording of asset and liability will be at the same value and the accounting entry for right of use of asset and lease liability will be as follows:

Debit: Right of use asset                                                               $5,000

Credit: Lease Liability                                                                     $5,000

 

Depreciation of right of use assets:

Once a right of use asset has been capitalized, its useful life shall be assessed. This useful life will become the basis of calculation of depreciation on right of use asset. Thus, although these assets are not legally owned by the lessee, depreciation will be charged on right of use assets, recognized as per requirements of IFRS 16.

Rent Expense:

IFRS 16 does requires that rent expense shall not be reported or recognized in the profit and loss statement (or in the books of accounts). This is because, IFRS 16 is treating this item effectively as an owned asset (i.e., right of use asset). So, there cannot be a rent expense booked for the assets which has been classified as right of use assets. But depreciation on these assets will be booked and presented in P&L, as discussed above.

Unwinding of discount (or interest expense):

After the initial liability is recognized (as stated above) on the implementation of IFRS 16 (or on booking of a new right of use asset), we need to calculate and incorporate interest expense from time to time. This interest expense is for the time period for which the liability remains outstanding. Let’s say that if we recognized a liability of 1 January 2019, we need to book interest expense on this liability once we reach the month end closing on 31 January 2019. The accounting entry for the interest expense will be as follows:

Debit: Interest expense ($5,000 X 5% X 31/365)                 $ 21.23

Credit: Lease Liability                                                                $ 21.23

The above entry would keep increase the liability amount.

Payment of lease liability:

Once the lease liability is paid, the liability will be debited and the bank account will be credited. This is as per normal accounting practices.

Accounting for short term leases:

There will be no recognition of a right of use asset or a lease liability once a lessee enters into a leasing arrangement. Therefore, there is no depreciation charge and no interest charge as well.

Accounting for Lessor:

The lessor shall identify whether it is an operating lease or a finance lease and then will account for it accordingly. A finance lease is a lease which substantially transfers risks and rewards associated with the asset. All other leases are operating leases.

While accounting for a finance lease, lessor shall recognize a lease receivable amounting to net investment in the lease.

 

Key features of IFRS 16:

• IFRS 16 does not provide options. It instructs to follow a single model. If the lease period is more than 1 year, the lessee MUST recognize right of use assets and corresponding long term lease liability. There is no option or choice available. This enhances consistency of financial statement presentation and enhances investors’ confidence on financial reporting.

• Materiality, as a basic accounting feature, is still an important factor. If the lease amount is not material then lessee is not burdened with unnecessary recognition of right of use assets and lease liabilities.

• Lessor’s are allowed to continue to adopt the same approach of operating lease or a finance lease as it was available under IAS 17 – Leases.

• First time adoption of IFRS 16 allows the adoption to be prospective or retrospective. Propsective application is simplified method of IFRS 16 adoption, under which you don’t need to restate the figures of comparative period. In full adoption method, the figures of comparative period of 2018 have also to be complied as if IFRS 16 was in effect from 1 January 2018.

• Assets shall be subsequently measured at cost model (or revaluation model if that asset comes under a class which is measured at revaluation model by lessee) or at fair value model if it is an investment property (if the policy of the lessee is to use fair value for investment properties).

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[vc_row][vc_column][vc_column_text]A discount is kind of a concession or waiver from the original obligation.

For example, if a prisoner is jailed for four years but is released after four years, he has got a discount of one year. Now, this example is not in business context, but to explain the discount.

In a business context, if a company had to pay $100 to a supplier and the supplier offered to make payment of $95 only against full settlement, it means that the supplier has given a discount of $5.

 

Trade Discount (or bulk discount)

A trade discount is a discount which is given at the time of trading (i.e., the discount given at the time of making the deal).

For example, you get a quotation from a car dealer for annual maintenance contract of the car at a price of $500. Now, you want them to lower their price as if you feel that it is high. If they agree to bring it down to, say, $450, it means that you have been given a trade discount.

Normally trade discount is offered when a bulk purchase is made. For example, if standard price of a watch is $100 and you want to purchase ten such watches, you might be offered a bulk purchase discount of 10% on total price. In this case, you will have to pay only $900 (instead of $1,000) for ten watches.

Another reason of offering a trade discount is the long term relation between customer and supplier. If there is a longstanding customer, the supplier may be willing to sale products at a discounted price than standard rate.

Some suppliers who are relatively new in business would consider offering trade discounts to new customers as well in order to make long term relations with them.

 

 

Accounting entries for trade discounts:

The general ledger entries done by bookkeepers for trade discounts or bulk discounts is usually, not recorded in the books of accounts of the company. This is because sales value has to be booked as per the contractual terms agreed between customer and seller.

For example, if a company sells a trolley bag at a price of $45 whose standard price is $50, it means that the company has offered a trade discount of $5 to its customer. Now, the deal is done at $45 and therefore, applicable accounting standards would require sales amount to be booked at the value of the consideration agreed between parties. The accounting entry for this sale will be as follows:

Debit: Customer account                              $45

Credit: Sales Account                                      $45

As you can see above, there is no space available for the discount to be recorded as account double entry is of equal amounts on debit and credit sides.

 

Needs for recording trade discounts:

However, from a management reporting point of view, financial analysts would want to know how much trade discount was offered to the customers during a particular month or a year. Similarly, to which customers trade discount was offered and by how much. From an internal and external audit point of view, auditors would want to check if the approvals for trade discounts were properly obtained. From an internal controls point of view, management would be keen to ensure that no unauthorized approvals are given for the trade discounts.

All of above requirements (management information system, audits, internal controls, performance measurement, sales performance etc.) require that trade discounts should be recorded and reported appropriately.

 

Recording trade discounts:

Although we cannot record trade discounts in our accounting books as this is prohibited by GAAP. But we can incorporate this in our management information system (MIS). A good MIS would have standard price of each product in the system. Any trade discount offered by sales team (after due approvals) would be entered in system and system would keep the record of trade discount offered. Later on, a report can be extracted from system for performing various types of analysis on discounts offered. However, this discount will not be reported in the company’s income statement.

 

 

Cash discount or Settlement Discount

Cash discount (or settlement discount) is an incentive offered to the customer for making early payment.

For example, if a customer has a credit period of 30 days for payment of $1,000, you can offer them an early settlement discount (or cash discount) of 2% if they make the payment within 10 days of the sale.

It is important to understand that cash discount does not necessarily require a ‘cash’ payment. The real objective of cash discount is to incentivize early settlement of the outstanding amount. Payment can be made using any mode like cash, cheque, bank transfer or credit card etc. As long as payment is made within the required time period, the customer will be eligible for the discount. Therefore, the cash discount may also be referred to as cheque discount, bank transfer discount, credit card discount, paypal discount etc. However, these terms are not common.

 

 

Accounting for Cash discount:

The cash discount shall be recorded in the books of accounts of the company as an expense. The cash discount will be booked as debit entry in the cash discount expense account and the respective credit will be provided to client’s account.

Cash discount is an expect for the company and thus will be classified in P&L as discount expense. In profit and loss account gross sales shall be reported as a top line. The discount given shall be then subtracted to arrive at net sales revenue figure.

Comprehensive example for cash discount:

Let’s say that Company A purchases 50 units of leather jackets at a credit period of 30 days, from an online retailer of leather jackets (i.e., www.smartleatherjackets.com). The standard price of these jackets is $100 per jacket. The supplier agrees to provide a 10% trade discount and additionally offers to provide 5% of settlement discount if payment is made within 5 days. Assuming that Company A makes payment within 5 days and avails cash discount. The accounting entries shall be recorded as follows in the books of supplier.

 

 

Deciding when to provide cash discount

When a company would want to offer cash discount is not an easy question. Financial analysts have to make carefully opportunity cost analysis to find out whether it is worthwhile offering cash discount or not. A cash discount offered will help in faster collection of receivables and thus interest cost of financing working capital (receivables) can be lowered. On the other hand, the amount of discount offered will be expense for the company. So, a cost benefit analysis has to be done. If the company is spending significantly on working capital investment and the early collection benefit is higher than the amount of discount offered, then offering discount is worthwhile. On the other hand, if the company is not incurring significant cost of financing working capital and there is no hurry to collect money from the customer, then offering discount will be expensive for the company. These decisions require significant study and analysis.

 

Practices of discounts in different industries

Retail or FMCG Sector

In retail sector, trade discount is most common. As an ordinary customer, if you enter a retail store, you might find some products on discount. Often in a sales promotion, you might get upto 50% off or 75% off etc. All this is practical example of trade discount.

There is no cash/settlement discount, usually, in retail sector for retail customers. However, corporate customers may still obtain a cash/settlement discount, in addition to trade discount.

 

 

Real estate sector

Cash discount/ settlement discount is quite common when it comes to buying a property. Many project plans offer 10% off or 5% off on full settlement of property price. This is a good practical example of cash/settlement discount in real estate sector.

Financial / banking sector

Often banks offer a settlement discount if you choose to close your mortgage by making a full payment of the total outstanding liability. This is an example of cash/settlement discount. However, this policy varies from place to place. Some banks charge a penalty for early settlement as well.

 

 

Electronics industry

If you are ordering bulk quantities of electronics equipement (say mobiles, headsets, chargers, powerbanks etc.) from China, you are likely to receive good trade discount. This means that you’ll get, say, 20% or 30% off on the standard product retail price. Trade discount is common across industries when it comes to buying in bulk quantities.

 

Conclusion

Understanding trade and cash discounts is relatively a simple topic. By now, you would be aware of nature of discounts, accounting entries and application of discounts in different industries. Providing discounts is an important economic phenome and it there are psychological implications of discounts as well. We will cover further details about discounts in more articles.[/vc_column_text][/vc_column][/vc_row]